Treating the Market Symptoms but Avoiding the Disease

By Inya Ivkovic, MA Published : August 20, 2007

I have a feeling that last Thursday, as long-term investors braced for the weekend, speculators rushed to accumulate as many shorts as possible that same afternoon. Sure enough, things went well overnight, with sinking Asian markets calling for yet another disastrous trading day in North America, perhaps of the same caliber as the 1987 market crash. But, come Friday morning, the U.S. Federal Reserve came out with a big bat and cut its discount lending rate by 50 basis points.

This discount rate is not to be confused with the funds borrowing rate. It just means that U.S. financial institutions are able to borrow money from the Fed at a lower rate. Individual borrowers were still left in a bit of a pickle, as interest rates on personal credit did not budge. To be fair, the funds borrowing rate couldn’t budge anyway, because this would have had to be the decision of the Fed’s Open Market Committee.

Still, it was a move that the stock markets on both sides of the border took as a positive sign that someone was at least attempting to deal with the collapsing credit market. But after billions of dollars being infused into the financial systems of both the U.S. and Canada, and after the discount rate cut, the Fed is again doing its usual song and dance — treating the symptoms, but not the disease.

Unfortunately, the disease — easy money — is potentially terminal. Because it is not so much about what the Fed does to curb the credit market collapse brushfire, and it is not how much optimism or pessimism exists in the stock markets. It is the spending mentality without regard for any fiscal consequence that is at the root of the problem. Even as fear shook the very foundation of the credit market — subprime and prime alike — and even as foreclosure signs started sprouting like mushrooms, the American consumer kept on spending. And I would have a hard time believing that the money they were spending came from savings.

In the spirit of fairness, I cannot ignore the short-term positive effects of last week’s string of decisions made by the Fed. The immediate result was a rally in the stock markets. But that was hardly enough to compensate for the brutal summer. Just to let you know, Canada’s S&P/TSX Composite has lost most of its 2007 gains in the last three weeks of trading.

The more significant effect of the Fed’s bailout should be the Bank of Canada’s stance toward interest rates. As our own mortgage- backed securities market has contracted, the consensus among economists now is that the September 5 interest rate increase is no longer likely. In fact, on October 16, forecasters actually expect a 25-basis-point interest rate decrease. (I told you so!) That’s the good news.

But as far as the stock markets are concerned, these rallies are very likely to be of a temporary nature; namely, the subprime problems, regardless of how much we may have wished for it, have not evaporated. By extension, hedge funds and other speculators are still very much exposed and are still looking for relief in the remaining fundamentally strong sectors, certainly spoiling the hard work of long-term investors.